Letter of Credit - Definition
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What is a Letter of Credit?
A Letter of Credit is a document provided by a credit-worthy bank to give assurance of payment to a seller of goods as long as the seller presents it with the correct documentation.
Mostly these letters are utilized in international trade where they are regulated by the rules of the International Chamber of Commerce in the form of Uniform Customs and Practice for Documentary Credits (UCP).
Who is Involved in a Letter of Credit Transaction?
The letter of credit is constituted by three parties:
- Beneficiary - The beneficiary (generally a seller) who receives payment,
- Applicant - The applicant (buyer of the goods) originates the letter of credit, and
- Issuing Bank - The institution which issues the letter of credit.
- Advising Bank - Bank that receives the letter of credit and will make payment on the letter to the Beneficiary. Also known as the Confirming Bank, Nominated Bank, or Prime Bank.
What is the Process of Using a Letter Credit
- The Beneficiary (Seller) and Applicant (Buyer) enter into a sales agreement for the goods in question.
- The Applicant (Buyer) approaches a financial institution (the Issuing Bank) about generating a letter of credit.
- The buyer generally has a bank account at the institution.
- The buyer specifies what is required for the bank to pay the letter of credit (generally receiving ownership documents - such as a Bill of Lading - for specific goods).
- The Applicant sends the letter of credit to the Beneficiary's financial institution (the Advising Bank).
- The Advising Bank will provide an Advising Letter of Credit to the Beneficiary.
- This allows the Beneficiary to receive payment upon presentation of shipment verification and Ownership Documents (such as a Bill of Lading).
- The Beneficiary ships goods to the Applicant (Buyer) and receives Ownership Documents
- These documents allow the holder to take possession of the goods upon arrival.
- The Beneficiary turns the Ownership Documents over to the Advising Bank.
- The Advising Bank sends the documents to the Issuing Bank.
- The Issuing Bank provides the Documents to the Applicant Seller and makes payment on the letter of credit to the Advising Bank.
- The Advising Bank then makes payment on the Advising Letter of Credit to the Beneficiary.
What are the Types of Letter of credit?
There are various categories of these letters. Examples of these categories include the following:
- Import/export: A single letter of credit can be either an import or export letter depending on the perspective of the user ( who can be either an importer or exporter)
- Revocable / Irrevocable: This determines if the buyer and the issuing bank can control the letter of credit without the seller's permission. In a revocable letter, changes or termination are channeled through the issuing bank by the applicant with the beneficiary's approval and authentication. However, this category is becoming irrelevant since UCP 600 considers all letters or credit as irrevocable.
- Confirmed/Unconfirmed: A letter of credit (LC) is confirmed when the Advising bank guarantees to honor a presentation put forth as a request by the issuing bank. If unconfirmed, the advising bank will only make payments on the documents once that payment is received from the Issuing Bank.
- Restricted/Unrestricted: In the case of a restricted LC, an advising bank can buy a bill of exchange from the seller. If a confirmation bank is not mentioned, an exporter can present the bill of exchange to any bank for payment on an unrestricted LC.
- Deferred/Usance: This is a credit that is assigned after a stipulated period accepted by the buyer and seller and not immediately after the presentation. The seller gives the buyer the authority to pay after he takes and sells the goods involved.
The following are some of the unique terms of the letter of credit that relate to the payment conditions in the underlying reference documents.
- At Sight: This is a credit that is paid as soon as possible by the Advising bank after it is done inspecting the seller's documents.
- Acceptance - If a letter of credit is against acceptance, the issuing bank will release the ownership documents to the Buyer upon receipt of a promise (Acceptance) to pay. It is an alternative to Cash Against Documents.
- Red Clause: This is a situation where the seller can deposit the prepaid money in the bank before he sends the products.
- Back to Back: This is issued for the purpose of promoting intermediary trade.
- Standby Letter of Credit: This is a letter of credit with the objective of providing a source of payment in the case of non-performance of a contract. It is used as a failsafe against an unfulfilled obligation.
Academic Research on Letter of Credit (L/C)
- The Law Merchant and the Letter of Credit, Trimble, R. J. (1948). Harvard Law Review, 61(6), 981-1008. This paper states that confusion and discrepancies are present in the decisions resulting from the discussion of the law regulating the LCs by many writes and the enforcement by many judges.
- Enjoining Letter of Credit Transactions, Harfield, H. (1978). Banking LJ, 95, 596. This article analyzes recent cases to confirm the independence of LCs contracts and justify the injunctive relief only in situations where there are egregious fraud and no prejudice to the rights of innocent parties.
- Enjoining Payment on a Letter of Credit in Bankruptcy: A Tempest in a Twist Cap, Chaitman, H. D., & Sovern, J. (1982). Bus. Law., 38, 21. This paper examines the Twist Cap decision and the theories of preference and executory contracts that the debtor advances with the aim of providing a basis for bankruptcy courts deny relief such as that granted in the Twist Cap.
- The No-Guaranty Rule and the Standby Letter of Credit Controversy. Lord, R. A. (1979). Banking lJ, 96, 46. This article presents an argument that claims that the no-guaranty rule cannot coexist with the law that allows standby letters of credit for much longer.
- Identity Crises in Letter of Credit Law,. Harfield, H. (1982). Ariz. L. Rev., 24, 239. This paper asserts that the main component of the utility of the letter of credit is its independence from other contracts, arrangements, and relationships which are part of the transaction from which the letter of credit arises.
- The Legal Nature of the Irrevocable Commercial Letter of Credit. Kozolchyk, B. (1965). The The American Journal of Comparative Law, 395-421. This article reviews a brief history followed by an examination of various theories that attempt to explain the nature of the irrevocable commercial letter of credit.
- Enjoining the International Standby Letter of Credit: The Iranian Letter of Credit Cases, Getz, H. A. (1980). Harv. Int'l. LJ, 21, 189. This article addresses the issues presented in the transactions of standby letters of credit where a sovereign state is deemed as the beneficiary of payment.
- Third-party certification in new issues of corporate tax-exempt bonds: standby letter of credit and bond rating interaction. Stover, R. D. (1996). Financial Management, 62-70. This paper extends the literature of commercial bank certification through the examination of the role of banks in issuing standby letters of credit in the corporate debt market which is tax-exempt.
- The paperless letter of credit and related documents of title. Kozolchyk, B. (1992). law and Contemporary Problems, 55(3), 39-101. This article explores the presentation of paperless documents of title for the fulfillment of a condition of payment since the time is getting closer when the paperless documents will be presented to banks.
- Practical Effect of the Uniform Commercial Code on Documentary Letter of Credit Transactions, Chadsey, H. M. (1954). University of Pennsylvania Law Review, 102(5), 618-628. This paper codifies the practices of the letters of credit as they exist in the United States and not revolutionize them.
- A comparative analysis of the standard of fraud required under the fraud rule in letter of credit law. Xiang, G., & Buckley, R. P. (2003). Duke J. Comp. & Int'l L., 13, 293. This article presents a clear standard as an improvement from those applied throughout the world and suggest a method for implementing it after analyzing the law in several countries.
- Fundamental Issues in the Unification and Harmonization of Letter of Credit Law, Byrne, J. E. (1991). Loy. L. Rev., 37, 1. This paper asks directional questions with the aim of yielding points that may be useful in plotting the course to be used in unifying and harmonizing the law of the letter of credit.
- Estimating the direct impact of bank liquidity shocks on the real economy: Evidence from letter-of-credit import transactions in Colombia, Ahn, J., & Sarmiento, M. (2013). Washington, DC: International Monetary Fund. This study examines the import transactions of the letter-of-credit in Colombia to provide an accurate estimate of the direct impact of bank liquidity shocks on actual economic activity.